Investing In Energy Vs Speculating In Oil

March 24, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Bob Leggett, senior portfolio advisor at Akron, Ohio-based ValMark Advisers, which markets the "TOPS" brand of asset allocation models.

 

West Texas Intermediate (WTI) crude oil prices dropped below $45 in February, testing the Great Recession low price for the commodity. Then, after bouncing back up to $50-plus, oil prices are again in the mid-$40s. Some see this as a bottoming pattern, which brings a few questions to mind:

 

  1. Can we know if it’s a bottom?
  2. How can we use ETFs to participate in potential oil price changes?

 

You probably noticed our first question begins with “Can we know” rather than “How can we tell.” Even if you gather a lot of data, scrutinize price charts and consult with the industry experts, we believe your odds of accurately forecasting the short-term price of oil are quite unfavorable.

 

Be Cautious Of ‘Surefire’ Pricing Models

Oil industry experts typically have mounds of data available to them, which allows them to construct strong cases to support forecasts. They can choose from supply data, demand data, storage data, seasonal data, geographic data, geopolitical data, alternative energy source data, etc.

 

Nonetheless, we have been unable to identify a forecaster who accurately predicted the 2008 WTI peak, 2009 trough as well as lower peaks in 2011, 2012, 2013 and 2014 lower peaks and, not least, the 2014 WTI plunge.

 

Simply stated, forecasting oil prices is very difficult, and recent currency fluctuations have contributed to this difficulty. WTI is priced in dollars, and the trade-weighted dollar has been markedly volatile. In previous commentaries here on ETF.com, we’ve discussed the impact of currency fluctuations on diversified global ETF portfolios.

 

More Factors Affecting Price

We know how challenging it is to develop investment disciplines regarding the efficacy of hedging currencies, so we sympathize with the experts on this topic.

 

In reading reports from various oil industry experts, we see numerous factors beyond those noted above that are cited as influencing the supply/demand balance. The list includes, but is not limited to: global GDP, exploratory drilling incentives, rig availability, costs of fracking, OPEC politics, gasoline subsidies, shipping costs, storage levels, refinery capacity, export controls and alternative energy incentives.

 

Blending these factors to turn a barrel of crude data into a gallon of refined forecasting is almost as complex as producing gasoline. We would caution investors against relying too heavily on the accuracy of oil price forecasts.

 

Using Oil ETFs

If an investor’s disciplines indicate that an allocation to energy-based ETFs is appropriate, the next step is making investment selections. We have used the Vanguard Energy ETF (VDE | A-96) which is diversified among the various sectors of oil and gas companies.

 

VDE has low expenses, typically lower volatility than oil prices and a low expense ratio, which makes it a reasonable commodity play for longer-term investors.

 

Investors should recognize there is some risk of disconnect between the prices of energy commodities and energy firms; however, that can be a good thing. For example, VDE lost 9.94 percent in 2014, compared with a 37.45 percent drop for the United States 12 Month Oil Fund (USL | C-75).

 

Future-Linked Oil ETFs

Apart from USL, alternatives for those who expect a WTI rally and wish to bet on it include the United States Oil Fund (USO | B-100).

 

Both aim to track the WTI through investing in oil-related futures contracts. The primary difference between the two is that USO uses the near-month futures, while USL equal-weights each of the next 12 months.

 

A big challenge for futures-based ETFs is that oil futures contracts expire monthly, so new contracts must be purchased to replace them. This “roll” can dampen portfolio returns due to transaction costs and the fact that replacement contracts for the next term are available at higher prices in an upward-sloping yield environment—a condition called “contango.”

 

Charting Returns

We compare the price of spot WTI with the ETFs VDE, USO and USL since 2007 in the following chart based on data from Bloomberg. Our client accounts currently hold VDE, but do not hold the other ETFs. 

 

 

Source: Bloomberg

 

VDE shows the virtues of diversification and is the only one that’s even close to breakeven over the time period shown. USO has lagged significantly due to the roll impact I discussed above. USL’s smoothing of the futures results in less roll impact, but it has still lagged WTI.

 

With VDE partly insulated from the sharp WTI price decline, it certainly appears the better bet for longer-term investors. However, VDE also insulates investors from sharp WTI price increases.

 

One interpretation may be that using an ETF that invests in company securities is better for long-term buy/hold investors but ETFs that use futures may be better for short-term speculators.


At the time this article was written, the author’s firm held shares of VDE in client accounts. ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email:[email protected]. Phone: 800-765-5201. For a complete list of relevant disclosures, please here.

 

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